By Allen Wastler, a former financial journalist with over 30-years of experience, including time at CNBC, CNN, and Knight-Ridder Newspapers.
Originally posted on Sep 14, 2020
Life insurance is, first and foremost, about protecting the ones you love after you’re gone. But some types can actually help you in retirement as well, by providing:
- A way to accumulate a source of funds.
- Tax-deferred growth insulated from market volatility.
- The option to take tax-deferred distributions.
Of course, life insurance should not be a primary source of retirement funding. If used in this way at all, it should be as an accompaniment to retirement accounts and investments made over the years. Whether it’s a good fit depends on your individual financial circumstances. And using life insurance in retirement will have negative implications for the policy’s value.
Nevertheless, for some people, life insurance may be a useful source for supplemental retirement income.
Cash value = A source of funds
Not all life insurance can provide a source of supplemental retirement income. This is only possible with types of permanent insurance, which include whole life, universal, and variable life insurance policies.
These types of policies build up cash value as policyowners make premium payments over time. In addition, some permanent insurance policies are eligible for dividends. While not guaranteed dividends, when paid, can be directed to enhance a policy’s cash value, among other options.
And policyowners can withdraw or borrow against their cash value for any need, like paying a college bill or coming up with a down payment on a house. Interest rates on cash value loans from insurance policies may be more favorable than those available for personal loans.
Of course, tapping a life insurance policy’s cash value decreases the remaining cash value as well as the death benefit. It also increases the likelihood the policy will lapse and may result in a tax bill if the policy terminates before the death of the insured.
Taking these cautions into account, the cash value of a permanent insurance policy can function as a ready reserve of funds should the need arise. And in some cases, that need may arise in the event of a market downturn.
Market volatility and retirement
The value of retirement accounts and equity investments can fluctuate. This can present problems for those depending on those investments for an income stream in retirement.
That’s because taking money from an equity-based retirement account (such as a 401(k) or IRA) during a market downturn will reduce the amount of principal that future returns will be based on. That degradation in compounding will likely be particularly troublesome if done in early retirement years.
“During accumulation, the average rate of return over time is the only thing that matters, but once you retire and start to draw down on your money, the sequence of returns comes into play,” said Douglas Collins, a financial planner with Fortis Lux Financial in New York. “All else being equal, a retiree who faces a bear market in the first few years has substantially less money than if they see the same bear market at age 90.”
Some retirees may have enough cash on hand to weather a market downturn without touching investments. Others may have taken advantage of annuities to provide a guaranteed source of income during their retirement years.
Also, knowing that markets do, from time to time, go down many investors try to diversify their investments with an assortment of vehicles somewhat insulated from equity markets, ranging from bonds to real estate to commodities.
Still, there are risks.
“In a severe bear market like 2008 and 2009, traditional diversification fails because every performing asset becomes correlated and sells off,” said Collins in an email exchange. “Having enough cash value in a whole life policy to weather the storm for just a few years of expenses greatly improves a retiree’s financial ability to fund their lifestyle without having to sell into a down market.”
There is another benefit in tapping the cash value of a life insurance policy to fund retirement expenses.
Money taken from the cash value of a life insurance policy is not subject to taxes up to the “cost basis.” That’s the amount paid into the policy through out-of-pocket premiums. It doesn’t include any of the tax-deferred investment gains or dividend additions the policy may have had.
So say, hypothetically, you bought a whole life policy in 1980 and paid $140,000 in total premiums. You could tap that as a partial surrender of the available cash value from the policy, based on the withdrawal provisions in the policy, and it would be income-tax free.
Alternatively, you could borrow against the cash value at any time and the amount borrowed would not be taxable as income, even if it is in excess of the cost basis ($140,000 in our hypothetical example). But that can done only as long as the policy is not a “modified endowment contract.” That’s a certain class of policies that receive less favorable tax treatment.
As noted earlier, using the cash value of an insurance policy in retirement will reduce its policy value and death benefit and increase the chance the policy will lapse. And if a policy lapses with an outstanding loan in excess of the cost basis, that portion is taxable.
Just in case
With hope, most retirees would never have to use the cash value of a whole life insurance policy, letting it instead serve its primary purpose: To leave a legacy for the protection and benefit of heirs and loved ones.
Nevertheless, a whole life policy can provide a valuable option for supplementing retirement income, particularly in a world where markets and investments can be volatile and unpredictable.
If you have questions about your personal retirement planning needs, and how a plan can be designed around your own unique circumstances, you may schedule a complimentary initial consultation at https://calendly.com/planningforgood/complimentary-initial-consultation-website.
Provided by Karen Melo Ticas, a Certified Financial PlannerTM practioner with Planning for Good, courtesy of Massachusetts Mutual Life Insurance Company. ©2020 Massachusetts Mutual Life Insurance Company, Springfield, MA 01111-0001. CRN202209-270839 / CRN202212-275121
Karen Melo Ticas is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. www.SIPC.org. Home office: 200 Clarendon Street, 19th & 25th Floors, Boston, MA 02116. 617-585-4500. The information provided is not written or intended as specific tax or legal advice. You are encouraged to seek guidance from your own tax or legal professional before making any decisions.